Chapter 10 - The Analysis of the Balance Sheet and Income Statement

CHAPTER TEN
The Analysis of the Balance Sheet and Income Statement

Stephen H. Penman

The web page for Chapter Ten runs under the following headings:

What this Chapter is Doing

The Separation of Operating Activities and Financing Activities: the Key

Question

Reformulated Balance Sheets and Income Statement: VF Corporation

Reformulated Balance Sheets and Income Statements for a Firm with Net
Financial Assets: Microsoft Corporation

Getting the Tax Rate for Tax Allocation in the Income Statement

Comprehensive Tax Allocation: A Diagram

Why do Firms Hold Cash?

The Apple Payout

Frustrations with Footnote Disclosure

Balance Sheets and Income Statements under IFRS

Some Differences in Reporting Between U.S. GAAP and IFRS

Classification of Expenses by Nature

Readers Corner

What this Chapter is Doing

Chapter 10 applies the template laid out in Chapter 8 to reformulate balance sheets and
income statements in a way that clearly distinguishes operations from the financing of
operations. Firms add value from operations trading with customers and suppliers not
from financing activities that involve raising cash and from claimants and returning cash
to them. GAAP financial statements, unfortunately, do not make a clear distinction. They
have to be cleaned up.

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Chapter 10 - The Analysis of the Balance Sheet and Income Statement

You may not see the payoff to the reformulation exercise at this stage, so the material
may seem a bit mechanical. But you will strike pay dirt as you proceed to the analysis of
profitability and growth (Chapters 12 and 13) and, particularly, as you carry out
valuations based on the reformulated statements in Part Three of the book.

Here, however, are a couple of teasers:

1. Analysts sometimes calculate the percentage profit margin as operating income

divided by sales. However operating income can include interest income on
financial assets (often lumped together with other (operating) income). And
operating income includes other income that does not come from sales equity
income from subsidiaries, dividend income, and gains from asset sales, to name a
few. The appropriate profit margin measure is:

Profit margin (from sales) = Operating income from sales/Sales

One must reformulate the income statement to differentiate income derived from
sales from other operating income.

2. Return on Common Equity (ROCE) is affected by both operating profitability

(RNOA) and leverage arising from borrowing. (Chapter 12 goes into more detail.)
Operations and borrowing have very different effects on the value of a share. So,
in analyzing ROCE and the amount of value it implies, one must be clear about
how much of the ROCE is due to the profitability of operations and how much is
due to leverage. Clean measures of the profitability of operations can only be
determined by a clean distinction between operating and financing items in the
financial statements.

The Separation of Operating Activities and Financing Activities: the Key Question

What is an operating item and what is a financing item? This is the question you will find
yourself asking as you reformulate financial statements. An operating item is one that is
involved in selling goods and services to customers or in trading with suppliers to
develop the products for customers. Or, another way to see it is to ask: How does the firm
make money and is the item involved in this activity? (The firm makes money by selling
products to customers, of course.) So, a note payable written to a supplier (a trade note) is
an operating liability, but a note written to raise cash for operations is a financing item.
Borrowings by a bank from which they lend at a higher rate than their borrowing rate are
operating liabilities, even though they look like a financing item.

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Chapter 10 - The Analysis of the Balance Sheet and Income Statement

Reformulated Balance Sheets and Income Statements: VF Corporation

VF Corporation is an apparel manufacturer, producing Lee and Wrangler jeans, Brittania

and Rustler brands, and Timber Creek cotton casuals. The GAAP balance sheets and
reformulated balance sheets for 1999 and 1998 are below.

VF Corporation
GAAP Balance Sheets
________________________________________________________________________
JANUARY 2 JANUARY 2
1999 1998
ASSETS
CURRENT ASSETS
Cash and equivalents $ 63,208 $ 124,094
Accounts receivable, less allowances of
$52,011 in 1998 and $39,576 in 1997 705,734 587,934
Inventories 954,007 774,755
Deferred income taxes 99,608 94,750
Other current assets 25,595 19,933
Total current assets 1,848,152 1,601,466
PROPERTY, PLANT AND EQUIPTMENT 776,091 705,990
INTANGIBLE ASSETS 951,562 814,332
OTHER ASSETS 260,861 200,994
$ 3,836,666 $ 3,322,782
LIABILITIES AND SHAREHOLDERS EQUITY
CURRENT LIABILITIES
Short-term borrowings $ 244,910 $ 24,191
Current portion of long-term debt 969 450
Accounts payable 341,126 301,103
Accrued liabilities 446,001 440,164
Total current liabilities 1,033,006 765,908

LONG-TERM DEBT 521,657 516,226

OTHER LIABILITIES 181,750 143,813

REDEEMABLE PREFERRED STOCK 54,344 56,341

DEFERRED CONTRIBUTIONS TO EMPLOYEE STOCK

OWNERSHIP PLAN (20,399) (26,275)
33,945 30,066
COMMON SHAREHOLDERS EQUITY
Common Stock, stated value $1; shares authorized 300,000,000; shares
outstanding, 119,466,101 in 1998 and 121,225,298 in 1997 119,466 121,225
Additional paid-in capital 801,511 744,108
Accumulated other comprehensive income (25,639) (36,110)
Retained earnings 1,170,970 1,037,546
Total common shareholders equity 2,066,308 1,866,769
$ 3,836,666 $ 3,322,782

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Reformulated Balance Sheets

________________________________________________________________________

1998 1997
Operating Assets
Cash $ 15,000 $ 12,000 (4)
Accounts receivable $ 757,745 $ 627,510
less allowances for doubtful accounts ( 52,011) 705,734 (39,576) 587,934
Inventories - Finished goods 552,729 434,000
- Work in process 185,929 166,947
- Materials 215,349 954,007 173,808 774,755 (6)
Other current assets 25,595 19,933
Property, plant and equipment - Land 45,296 44,786
- Buildings 443,619 437,903
- Machinery 1,222,216 1,086,263
1,711,131 1,568,952
less accumulated depreciation (935,040) 776,091 (862,962) 705,990 (6)
Goodwill 1,195,062 1,022,632
less accumulated amortization (243,500) 951,562 (208,300) 814,332 (6)
Deferred income tax asset 235,044 212,975
less valuation allowance (34,249) 200,795 (32,506) 180,469 (6)
Pension asset 35,164 27,713 (6)
Other assets 124,510 87,562
Deferred ESOP contributions 20,399 26,275 (7)

Operating assets 3,808,857 3,236,963

Operating Liabilities
Accounts Payable 341,126 301,103
Accrued liabilities - Taxes payable 70,112 86,244 (6)
- Compensation payable 103,769 84,425
- Insurance payable 18,605 62,153
- Other 253,515 207,342
Other liabilities - Deferred compensation 151,436 113,727 (6)
- Deferred income taxes 11,512 -----
- Other 18,802 968,877 30,086 885,080

Net Operating Assets (NOA) 2,839,980 2,351,883 (2)

Net Financial Obligations (NFO)

Short-term borrowings 244,910 24,191

Current portion of long-term debt 969 450
Long-term debt 521,657 516,226
Preferred stock 54,344 56,341 (5)
Financial obligations 821,880 597,208
Cash equivalents (48,208) 773,672 (112,094) 485,114 (3) (4)

Common Shareholders Equity (CSE) 2,066,308 1,866,769 (1)

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Notice several things about the reformulated statement (numbers refer to the numbers
flagging items in the exhibit):

(1) The reformulation maintains the balance sheet equation: CSE =

(2) NOA NFO
(3) Net operating assets (NOA) is the difference between operating assets and
operating liabilities
(4) Net financial obligations (NFO) is the difference between financial obligations
and financial assets
(5) Cash and cash equivalents have been divided up between operating and
financial assets
(6) Redeemable preferred stock are a financial obligation
(7) Considerably more information has been brought into the statements from the
footnotes:
Details on inventories, property, plant and equipment, intangibles, and
accrued liabilities are given.
The valuation allowance for the deferred tax asset (that discounts the
asset for the likelihood that the tax benefits will not realized) is given.
Detail on other assets is given, including a pension asset (for
overfunding of the pension plan) and deferred tax assets. Unidentified
other assets are treated as operating assets.
-- Details of accrued liabilities and other liabilities are given.

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Reformulated Balance Sheets and Income Statements for a Firm with Net
Financial Assets: Microsoft Corporation

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Chapter 10 - The Analysis of the Balance Sheet and Income Statement

GAAP INCOME STATEMENT:

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REFORMULATED INCOME STATEMENT:

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Getting the Tax Rate for Tax Allocation in the Income Statement

The reformulation of the income statement requires allocation of taxes to the operating
activities and the financing activities. The allocation uses the marginal tax rate. In almost
all cases, except where the firm cannot get the tax benefit of debt because it has operating
losses that cannot be utilized in its tax return, the marginal rate is the statutory rate. In the
US, the statutory rate is the federal rate (currently 35%) plus the rate for any state taxes.
As state taxes are deductible on firms federal tax return, the state rate is the nominal rate
multiplied by (1 0.35). So for a state tax rate of 3%, the rate to use in the allocation is:

Combined federal and state tax rate = 35% + 3%(1 - 0.35)

= 36.95%

Tax rates can be obtained from the tax footnote. Here is the tax footnote from the 2002
10-K for Dell Computer.

NOTE 4 - Income Taxes

The provision for income taxes consists of the following:

Fiscal Year Ended

-------------------------------------------
February 1, February 2, January 28,
2002 2001 2000
------------ ------------ -------------
(in millions)
Current:
Domestic $ 574 $ 964 $ 1,008
Foreign 59 168 84
Deferred (148 ) (174 ) (307 )
---- ---- -----
Provision for income taxes $ 485 $ 958 $ 785
---- ---- -----

Income before income taxes and cumulative effect of change in accounting principle included
approximately $302 million, $491 million, and $449 million related to foreign operations in fiscal 2002,
2001, and 2000, respectively.

The Company has not recorded a deferred income tax liability of approximately $711 million for additional
taxes that would result from the distribution of certain earnings of its foreign subsidiaries if they were
repatriated. The Company currently intends to reinvest indefinitely these undistributed earnings of its
foreign subsidiaries.

The components of the Company s net deferred tax asset are as follows:

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Chapter 10 - The Analysis of the Balance Sheet and Income Statement

Fiscal Year Ended

----------------------------------------
February 1, February 2, January 28,
2002 2001 2000
----------- ----------- ------------
(in millions)
Deferred tax assets:
Deferred service contract income $ 165 $ 148 $ 125
Inventory and warranty provisions 133 81 60
Provisions for product returns 58 44 30
and doubtful accounts
Loss carryforwards - 73 219
Credit carryforwards 115 188 101
Other 167 64 -
--- --- ----
638 598 535
Deferred tax liabilities:
Unrealized gains on investments (26 ) (47 ) (303 )
Other - - (74 )
--- --- ----
Net deferred tax asset $ 612 $ 551 $ 158
--- --- ----

Tax credit carryforwards will generally expire between 2003 and 2023.

The effective tax rate differed from statutory U.S. federal income tax rate as follows:

Fiscal Year Ended

------------------------------------------
February 1, February 2, January 28,
2002 2001 2000
------------ ------------ ------------
U.S. federal statutory rate 35.0 % 35.0 % 35.0 %
Foreign income taxed at different (6.6 ) (5.8 ) (6.0 )
rates
Nondeductible purchase of - - 2.8
in-process research and development
Other (0.4 ) 0.8 0.2
---- ---- ----
Effective tax rate 28.0 % 30.0 % 32.0 %
---- ---- ----

The tax rates are given at the end of the note. Dell in a Texas company where there are no
state taxes, so the statutory rate is the federal rate of 35%. Note that the benefits of lower
taxes in foreign companies do not affect the rate used for the tax allocation: these are
benefits that go to the operations, not the financing activities.

Here is the relevant tax rates from IBMs 2002 10-K. You see the state tax rates there.
(From IBM 2002 10-K)

A reconciliation of the company's continuing operations effective tax rate to the

statutory U.S. federal tax rate is as follows:

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FOR THE YEAR ENDED DECEMBER 31: 2002 2001 2000

-------------------------------------------------------- ---- ---- ----
Statutory rate 35 % 35 % 35 %
Foreign tax differential (7) (6) (6)
State and local 1 1 1
Valuation allowance related items - - (1)
Other - (1) 2
---- ---- ----
Effective rate 29% 29% 31%
---- ---- ----

Some firms do not report taxes rates, only dollar amounts of federal and state taxes. The
federal rate is always 35%, and the state rate (in this case) has to be interpolated from the
dollar numbers.

Comprehensive Tax Allocation: A Diagram

This chapter described how taxes are allocated between components of the income
statement (see particularly Box 10.3). This is the allocation that the analyst does.
However, GAAP has also carried some tax allocation, for example always allocating
taxes to items below the tax line in the income statement and to other comprehensive
income items. The diagram below describes:

(1) How recorded taxes differ from taxes paid (by recognition of deferred tax assets
and liabilities)
(2) How GAAP then allocates the accrued taxes to items in the financial statements
(3) How the analyst then extends the allocation (as in this chapter)

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(next page)

Tax Allocation

Cash Taxes Paid (on Taxable Income)

Deferred Taxes
(Interperiod Allocation)

Deferred Tax Assets Income Tax Expense Deferred Tax

Liabilities

Intraperiod Allocation

Lines above Tax Expense: Lines below Tax Expense:

Taxes not allocated to Taxes allocated to line
line items; tax on one line, items
Income Tax Expense

The Analyst Allocates:

- Allocation to financing and operating activities
- Allocation to components of operating activities

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Why do Firms Hold Cash?

There are a number of reasons (see also Box 10.2 in Chapter 10):

1. To grease the working of the operations. This is typically a very small amount of
cash, called working cash. This is sometimes called the transactions demand for
cash.
2. For ultimate payout to shareholders
3. To settle debt in the future
4. For making future investmentscapital expenditures or acquisitions. Firms might
hold more cash for acquisitions when their stock price is low, for then they would
prefer to use cash rather than stock in the acquisition.
5. As a precaution against a rainy day. This is sometime called the precautionary
demand for cash. See the discussion in Chapter 10.
6. For tax reasons: U.S. corporations incur taxes when they repatriate cash back to
the U.S. from overseas subsidiaries. So they hold the cash overseas.
7. To waste it: management holds cash for suboptimal investments the corporate
jet rather than paying it out to shareholders. Entrenched managers build excess
cash balances (it is said) to spend on empire building and pet projects.

The last point is sometimes referred to as the free cash flow hypothesis---too much free
cash results in waste.

The Apple Payout

After accumulating nearly $100 billion in cash (financial assets), Apple Inc. announced
in early 2012 that it would start to pay a dividend. A newspaper article that followed up
on the announcement claimed that this would do nothing for shareholders, invoking the
Miller and Modigliani principle that paying dividend does not increase value. Rather,
claimed the article, Apple should be scouring the globe to find companies to buy up
with the cash, perhaps a cable company, or telecoms with bandwidth.

Is the article correct? Well, they are correct on the M&M point: dividends will not add
value. But on the point that the cash should be kept for investment, it is incorrect. First,
making poor investments does not add value. But, second, if good investments could be
found that mesh with Apples business model, the firm can also borrow to fund the
investment (or to pay out dividends). Indeed, that is what the M&M principle says: firms
can pay out dividends (and not affect their investment opportunities) because they can
also borrow. The firm cannot be capital constrained, of course, but Apple would have
little problem borrowing to make an acquisition. Indeed, for an acquisition, it can issue
stock rather than pay cash.

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Chapter 10 - The Analysis of the Balance Sheet and Income Statement

Frustrations with Footnote Disclosure

To reformulate financial statements, one needs to refer to the footnotes to get more detail
first, to identify items as operating or financing and, second, to bring more detail up
onto the face of the statement. Here are some of the frustrations you might run into:

Other income from operations is lumped together with interest income (from
financing activities)
There is not a lot of detail given for SG&A expense, even though this is often a
large percentage of sales. Advertising costs are usually identified, but little else. It
is not clear whether SG& A contains expenses not related to sales (that should be
part of other operating income not from sales). Firms have been known to credit
gains on asset sales to SG&A (IBM, in 1999, for example).
Other Assets and Other Liabilities are not detailed

Balance Sheets and Income Statements under IFRS

The following web site prepared by Deloitte Touche Tohmatsu, the accounting firm, gives
the layout of financial statements prepared under international accounting standards:

http://www.iasplus.com/fs/fs.htm

See in particular the tab for model IFRS financial statements.

The Chapter 9 web supplement gave the equity statement for Siemens, the large German
electronic and engineering firm. Here are the accompanying balance sheet and income
statement for 2011. Notice the two-statement format for reporting comprehensive
income.

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Chapter 10 - The Analysis of the Balance Sheet and Income Statement

Some Differences in Reporting Between U.S. GAAP and IFRS

Here are some differences between IFRS and GAAP:

1. IFRS permit expenses in the income statement to be classified by nature (eg.,

personnel costs, raw materials costs) or by function (eq., selling costs, R&D costs)
while GAAP permits classification only by function.
2. IFRS requires all deferred tax assets and liabilities to be classified as noncurrent
while GAAP requires classification as current or noncurrent based on the nature
of the item that underlies the deferred tax item.
3. IFRS lease classification guidelines do not set numerical thresholds, unlike
GAAP.
4. IFRS requires debt issue costs to be expensed while GAAP permits capitalization
as an asset (to be amortized).
5. Reg. S-X requires three years in the comparative income statement, whereas IFRS
requires only two.
6. IFRS has no extraordinary item category.

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Classification of Expenses by Nature

As indicated above, U.S. GAAP required expenses to be classified by function rather than
nature. An exception is airlines. Here is the income statement Delta Airlines, classified by
nature:

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Readers Corner

A paper on the strategic aspects of large cash balances:

W. Mikkelson and M. Partch, Do Persistent Large Cash Balances Hinder

Performance? Journal of Financial and Quantitative Analysis (June 2003): 275-
294.

A paper that shows how the separation of operating and financing activities relates to
valuation:

J. Feltham, and J. Ohlson., Valuation and clean surplus accounting for operating
and financing activities, Contemporary Accounting Research 11 (1995): 689
731.

Two papers that investigate cash holdings of firms:

T. Bates, K. Kahle, and R. Stulz, Why Do U.S. Firms Hold So Much Cash than
They Used To? Journal of Finance LXIV (October 2009): 1985-2101.

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